WRITTEN COMMENTS OF THE OPEN SOCIETY JUSTICE INITIATIVE
on the Consejo para La Transparencia’s Draft Regulations Regarding Disclosure of Remuneration for Public Companies and State Owned / Controlled Companies
I. Introduction and Statement of Interest
The Open Society Justice Initiative provides this submission to assist the Consejo para la Transparencia (hereafter “Consejo”) in developing regulations concerning the disclosure of remuneration for Executives and Directors of public companies and state-owned or state–controlled companies (the “Regulations”).
The Justice Initiative, a worldwide legal program of the Open Society Institute, pursues law reform activities grounded in the protection of human rights, and contributes to the development of legal capacity for open societies. The Justice Initiative combines litigation, legal advocacy, technical assistance, and the dissemination of knowledge to secure advances in four priority areas: national criminal justice, international justice, freedom of information and expression, equality and citizenship, and anti-corruption. Its offices are in Budapest (Hungary), New York (United States) and Abuja (Nigeria).
In the area of access to information, the Justice Initiative has extensive experience in promoting the adoption and implementation of freedom of information laws in Eastern Europe, Latin America, and elsewhere. It has also contributed to international standard-setting and monitoring of government transparency around the world. The Justice Initiative files amicus curiae briefs with national and international courts and tribunals on significant questions of law where its thematically focused expertise may be of assistance. In the area of freedom of expression and information, the Justice Initiative has provided pro bono representation before, or filed amicus briefs with, all three regional human rights systems and the UN Human Rights Committee. In particular, the Justice Initiative, jointly with four other groups, filed amicus curiae briefs with both the Inter-American Commission and the Inter-American Court of Human Rights in the landmark case of Claude Reyes et al v. Chile.
The Regulations proposed by the Consejo require public companies and state owned or controlled companies (collectively referred to herein as “SOEs”) to publicly disclose several categories of information including (i) constitutive documents and the legal framework applicable to such companies, (ii) organizational structure, (iii) financial conditions, (iv) related companies, and (v) the directors and management group. Our comments address only those portions of the Regulations related to the disclosure of remuneration practices of Chilean companies.
Substantial attention has been devoted in recent years to the regulation of executive remuneration. Our research indicates that the clear international trend is to require disclosure of remuneration paid to officials, both of companies that are not affiliated with the state but which are publicly traded on a national stock exchange as well as SOEs.[1]
Section II of these Comments sets forth seven arguments that have been advanced to justify and advocate for robust disclosure requirements by numerous experts, including experts on practices in China, Switzerland, Australia, the U.S., U.K., EU and OECD. Section III summarizes the disclosure requirements found in various developed and developing countries. Section IV concludes that the disclosure regulations promulgated by the Consejo are consistent with policies and principles underlying democratic institutions, transparency, democracy and good corporate governance, and offers some additional recommendations that the Consejo may wish to take into account as it continues to elaborate and apply guidelines regarding disclosure requirements for Chilean companies.
II. Policy Justifications for the Proposed Regulations
Disclosure requirements serve several important functions in ensuring transparency and openness in corporate governance. This Section provides an overview of these functions.
a. Requiring disclosure of remuneration makes directors and executives more accountable to shareholders and the public at large.
Where remuneration is set by an agent (such as a board of directors), there must be a certain level of accountability in order to prevent self-dealing among the board and the executives. The disclosure regime proposed in the Regulations increases this accountability.[2] The board must “certify” (through disclosure) that the remuneration is reasonable and promotes shareholder interests. Disclosure causes the board to justify its pay choices publicly and with more care.[3]
If the shareholders do not believe that the board is fulfilling its duties with respect to remuneration, they can dismiss directors that are not acting in the corporation’s best interests or adopt new corporate resolutions that prevent such abuses.[4] The act of disclosing compensation allows shareholders to act as corporate monitors and keeps the behavior of those in charge of compensation in check by exposing any potential self-dealing or corporate waste in the form of unjustified compensation packages.[5]
b. Disclosure permits shareholders to effectively monitor management and remuneration practices and reduce costs of the agency relationship between shareholders and executives.
In the typical corporate governance structure, the owners of the company (shareholders) do not manage the company’s affairs. The owners rely on hired managers (executives) to run the enterprise for them. This dynamic creates an agency relationship between the shareholders and the executives (agents), which inherently creates a conflict.[6] With respect to executive compensation, the interests of the executives (one of which is to maximize their own compensation) are not clearly aligned with those of the shareholders – to maximize the value of the company.[7]
Shareholders can reduce the conflict by monitoring management to ensure that management does not act in its own self-interest.[8] Constantly monitoring management, however, is time consuming and costly, and it is unlikely that any single shareholder will have sufficient incentive to monitor management.[9] Shareholders have only a fractional interest in firm profits and are not incentivized individually to monitor and discipline management.[10] Even when the information is obtained after such effort, it is in a format that would be hard to compare to other companies in a meaningful fashion.
Uniform disclosure of executive and director compensation, as it is proposed in the Regulations, is an effective method of combating this conflict in a way that lowers the shareholders’ monitoring costs.[11] As stated by Rashid Bahar, an expert at the University of Geneva:
Over the last decade, regulators and promoters of corporate governance codes have increasingly relied on transparency to resolve the conflict of interest in executive compensation. This increased disclosure is implemented by statute, agency regulation, or corporate governance codes. This approach is based on the underlying assumption that if investors are informed of the compensation scheme, they will be again in a position to check and react against managerial excesses. In other words, by forcing companies to disclose information the proponents of this approach hope to lower the costs of monitoring by shareholders and reduce the agency costs linked to executive compensation.[12]
Greater monitoring of remuneration through mandatory disclosure of executive pay as set forth in the Consejo’s proposed Regulations would strengthen the correlation between executive compensation and firm performance and would reduce the agency costs inherent in this relationship.[13]
c. The increased transparency resulting from disclosure increases “outrage costs” and is accordingly a strong constraint against managerial abuse.
As noted above, because shareholders are often unable to effectively monitor management, directors and executives may be able to extract excessive remuneration packages. Scholars argue that shareholder and public “outrage” can act as a counterbalancing constraint on the power of management to extract such excessive remuneration.[14]
Such outrage may produce an additional constraint on excessive remuneration packages as directors and management may be unwilling to adopt remuneration arrangements when faced with such a reaction from shareholders and the public. This reaction is referred to as the “outrage cost” that directors and management must weigh against the particular benefits of a remuneration package when considering whether to adopt or approve it. When the cost is sufficiently high, management may find itself unable to justify certain compensation practices because of the reputational damage that might follow or a desire to avoid being perceived as an “outlier” and the potential for negative publicity.[15] Evidence in the United States as well as the United Kingdom and Australia suggests that this “outrage cost” can be an effective restraint on managerial power.[16]
In order for this “outrage cost” to function effectively, the outrage must be sufficiently widespread “amongst relevant groups of people.” If the outrage is not sufficiently widespread, management will have little or no incentive to take the potential outrage cost into account when considering remuneration packages.[17] Relevant groups include investors, media, and social and professional groups about whose views the executives and directors care.[18] Accordingly, transparency may enhance this “outrage” cost via a multiplier effect – the greater the required disclosure and the more widely available such disclosure is made, the more likely a greater portion of the public will experience this outrage, thus enhancing the “outrage cost” that may result from approving such compensation packages.
d. Disclosure encourages the development of norms regarding remuneration practices.
The disclosure requirements in the Regulations will make available to shareholders and the public valuable information that “signals” management’s view of “acceptable and appropriate” remuneration. This signaling and feedback process plays an important role in ensuring that companies adopt remuneration practices that are reasonable and norm-adjusted. As all companies fulfill their disclosure requirements and a greater amount of information becomes available regarding remuneration practices, norms regarding “acceptable and appropriate” remuneration practices may start to develop.[19] Companies will then likely find it difficult to stray from these norms without a clear justification for doing so.
Mandating disclosure is crucial in ensuring the effective functioning of this process: without such disclosure requirements, interested parties would likely find it impossible to obtain reliable and complete information regarding the remuneration practices of companies. Even if they are able to obtain such information regarding a particular company, it is of limited utility when they are unable to compare it to the practices of other similar companies.
e. Requiring disclosure is a cost effective and less intrusive method of controlling compensation than other methods that have been tried.
Although some costs will be incurred in preparing information that must be disclosed, the costs of such efforts likely are outweighed by the costs that would result from requiring companies to adopt remuneration practices that comply with some legal or judicial limit.[20] Moreover, disclosure will only indirectly impact on remuneration practices of companies thus ensuring that companies efficiently allocate resources. This should be compared to the experiences of other countries that have sought to regulate and limit remuneration through other more costly and intrusive measures.
For example, in the United States, provisions in the tax law seek to directly limit remuneration through the denial of tax benefits. These include (i) Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), that limits public companies from taking a deduction for remuneration for certain named executives that is in excess of USD $1 million (unless such remuneration qualifies as “performance-based” under detailed rules) and (ii) Code Section 280G, that both denies a company a deduction for and imposes a 20% nondeductible “excise tax” on a recipient of, an “excessive parachute payment” or “golden parachute” payment (very generally defined as a payment that is contingent on a change in control of the company and that exceeds a certain base amount). More recently the United States has enacted detailed and onerous requirements aimed at regulating and limiting the ability of executives to defer the receipt of remuneration. [21] Companies have expended countless resources in designing remuneration packages that are intended to comply with these provisions and it is debatable what effect they have had on remuneration.[22] Whether such limitations are an effective way of regulating remuneration or misguided efforts, it remains that disclosure can play an important role in ensuring transparency regarding remuneration practices in a far less intrusive manner and without these potential unintended consequences.
f. Requiring disclosure in the case of state owned / controlled enterprises (SOEs) is an important part of ensuring proper corporate governance of such companies.
Lack of transparency is one of the largest problems in the corporate governance of SOEs. According to a study conducted by the World Bank, lack of transparency “undermines the ability to monitor management, limits the accountability of management and the government, and can conceal liabilities that can have an impact on national budgets and even financial stability.”[23] The study concludes that lack of transparency can limit the ability of a country to attract capital at competitive rates, build efficient and trusted institutions, and maximize its economic growth.[24] Transparency and disclosure prevent the corruption and unchecked management practices that investors fear in SOEs and allow for fairness and the predictability of the rule of law.[25] A reason for this lack of transparency is that government and individual officers in these enterprises attempt to promote their own political or individual goals.[26]
The Organization for Economic Co-Operation and Development (OECD) has published Guidelines on Corporate Governance of State-Owned Enterprises.[27] Chapter V, on Transparency and Disclosure, provides that SOEs should be subject to (1) an annual independent external audit based on international standards[28] and (2) the same high quality accounting and auditing standards to which listed companies are subject, including the requirement to disclose remuneration policies.[29] The Consejo’s proposed Regulations fully comply with the Guidelines proposed by the OECD.
Requiring disclosure of remuneration practices is made all the more important in SOEs where the “shareholders” (e.g., taxpayers) are unlikely to be able to exercise the same influence over management as shareholders of a company that is not affiliated with the state. Moreover, unlike in the case of a publicly traded company not affiliated with the state (where shareholders may express their disapproval of remuneration practices and management generally by selling their shares), taxpayers often have limited means for expressing their disagreement with management of SOEs. Therefore, ensuring transparency and the availability of information regarding remuneration practices of SOEs is an important part of ensuring good corporate governance and may also enhance the public’s trust in SOEs.
Requiring such disclosure is also justified by the fact that corporations (including state owned/controlled ones) derive benefits by their very status of being corporations. For example, corporations enjoy the benefits of the rule of law (limited liability, etc.) as well as a legal and regulatory framework within which they may operate. With such benefits comes a responsibility to the public, and disclosure is part of the corporate responsibility to the public to control profligacy and self-dealing.